Alibaba Group Holding Ltd And Oracle Corporation: A Tale of Two Technology Stocks

Over the last 12 months the company has brought in $8.5B in revenues, $3.7B in net income, and top line growth of about 50 percent year over year. The $3.7B in net income (or free cash flow) equates to about $1.69 per share and a simple P/E of around 53.

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Established, Cheaper

Some investors were disappointed by the latest earnings report which showed mixed overall results and brought the stock down about 6 percent. Oracle, over the last 12 months, has brought in $38.5B in revenues, $14.8B in net income, and delivered top line growth of about 3 percent year over year. The $14.8B in net income (or free cash flow) equates to about $3.00/share and a P/E of around 12.9.

The Better Buy?

Does the much higher growth rate for Alibaba make that stock the better buy despite the much higher valuation ratios? Or does the significantly lower price to revenue, free cash flow, and earnings ratios of Oracle make that a better pick?

The answer depends on an investor's growth expectations and risk tolerance.

Instead of trying to come up with a ‘fair value' for both companies, another (and more useful in this case) metric comes from solving for another variable. Assuming an investor demands a 10 percent total return for either stock, consider how much future earnings growth is needed to generate that return given current valuations.

Using a discounted cash flow model with the current cash flows, a 10 percent discount rate, and the current stock prices as hard inputs, the future growth rates to justify current valuations can be calculated.

Growth Expectations

For Alibaba free cash flow must grow at an annual 30 percent for the next five years, 18 percent for the following five years, and then slow down to an overall GDP pace of around three percent per year. Many other ‘combinations' of growth will get close to the same answer, but this version gives a good idea of the ‘breakeven' expectations.

For Oracle, the bar is set much lower. Oracle simply has to grow at three percent per year for the next 10 years, and 2.5 percent thereafter to get an investor 10 percent on their money.

The analysis does not tell you what stock will return the most over the next 10 years, but gives an investor a good idea of the future growth levels the companies have to achieve to get the same amount of total return (10 percent per year).

Value and more conservative investors will most likely be attracted to the more predictable cash flows and modest expectations built into Oracle stock , while growth investors would prefer the explosive potential of Alibaba.